This piece is the first of three articles designed to introduce futures and the role they play in a portfolio. Futures are more commonly used by institutional investors, so this series aims to demystify them for retail investors by explaining what they are, their benefits, common terms, and risks. In addition, a worked example demonstrates how investing in futures works. The following articles dive deeper into different types of futures: micro futures with a focus on equity index and crypto.
What are futures?
Futures might sound complicated, but strip out the jargon and theyâre simply contracts that let you buy or sell an asset for a set price at a later date. So when itâs time to settle, youâre obliged to buy or sell the underlying asset at the agreed price regardless of its current price. Thatâs different from options, which let you buy and sell the underlying asset but without the obligation.
You can trade futures on a range of assets including commodities, stock indexes, currencies, precious metals, interest rates, and even cryptocurrencies. Theyâre fairly easy to trade too: the contracts are all standardized and trade on a futures exchange, so you can transfer or trade a futures contract as you would a stock, without fear of the other party defaulting. If you prefer contracts on customized or âone-of-a-kindâ assets, you can also consider forward contracts. They work like futures but are privately negotiated between two parties and carry a much higher default risk.
Why trade futures?
Investors who trade in the futures market usually have one of two aims: to hedge the price of an asset by locking in a future price or to speculate on the price direction of an asset. The latter group â also known as âspeculatorsââ seek to profit from the ups and downs of futures prices.
Hereâs an example: traders who expect oil prices to be substantially lower in a year could sell a futures contract that obligates them to sell oil at todayâs price one year from now. If their predictions are right, they would profit from the price difference between the contractâs price and the price of oil when the contract expires. But if theyâre wrong, theyâll make a loss. Now, a refiner could take the opposite end of those tradersâ contracts: theyâd choose to buy oil at a fixed price a year from now because they want to hedge their input cost, by lowering the risk that theyâd later have to buy oil to refine at a higher price than todayâs.
There are a few reasons to trade futures. For one, they can help diversify your portfolio. For another, they could potentially allow you to profit from your outlook on asset prices while providing a hedging benefit if youâre looking for price stability. Bear in mind, though, that hedging works both ways, so locking in the price now could also mean you lose out on favorable price movements. Plus in other jurisdictions like the US, you could benefit from tax advantages depending on the long and short-term capital gains tax rates.
And then thereâs leverage: see, the upfront capital required for futures is often substantially lower than the contracted value âalthough your gain or loss is still calculated as if youâd deposited 100% of the contract. With leverage, you have the potential to magnify both your gains and losses.
24/7 Futures trading and Comprehensive Resources to get you started đšâđ»
Experience around-the-clock trading flexibility with CME Group. Access diverse futures, manage risk, and enhance your skills with user-friendly tools, educational materials, and global regulation. Capitalize on opportunities anytime and anywhere.
Youâre getting the hang of futures now, so letâs keep that momentum rolling đȘ
Hereâs your next chapter: expand your knowledge, develop your personalized trade plan, and try it risk-free with the CME Group free âMaster the Trade: Futuresâ course.
Youâll discover expert strategies from industry professionalsand hear how they each approach and troubleshoot specific trading scenarios.
Plus, youâll dig into how you trade while using that insight to develop a plan based on your strengths and risk tolerance. When using the CME Institute Trading Simulator, you can test that strategy out risk-free.
Youâll end up with a tailored trade plan, developed throughout the course, that you can use whenever youâre trading futures: start refining your strategy today.
Whatâs the key terminology?
Before you start trading futures, you should be familiar with a few key terms:
Expiration: While stocks can be held in perpetuity, futures contracts have an expiry date. Any position you hold is automatically closed once the contract expires.
Settlement: This is how you choose to pay or âsettleâ your contract. Usually, thatâll be with cash or by physical delivery of the asset, but your form of settlement will depend on your individual needs, the underlying asset, and your aims (to speculate or to hedge).
Price limits: To maintain an orderly market with lower price volatility, most exchanges set a limit on how much higher and lower futures contract prices can move in a day. The limits depend on the underlying asset: the more volatile the asset price, the higher the limits.
Mark-to-market: This is the process of calculating the current market value of your futures contract daily, rather than letting your profit or losses accumulate before settling when the contract expires. This way, all accounts between the involved parties are settled at the end of each day. And because that means losses canât snowball, credit risk tends to be lower for futures.
Margin: When you trade futures, you only need to put down a small amount of money as collateral â your âinitial marginâ. Thatâs usually a percentage of the value of the futures contract, so you can trade a far bigger position than you otherwise could with a small deposit. But to keep holding your position, you need to make sure you have enough surplus funds,known as your âmaintenance marginâ. See, because the value of the future is adjusted daily, your deposit as a proportion of the overall value could drop below the required amount. If that happens, you might face a âmargin callâ that requires you to top up funds.
Worked example: hedging your portfolio with futures
Letâs see how you might use futures to hedge portions of your investment portfolio.
You currently own foreign property in the US, and recently closed a deal to sell the estate for $1.25 million (USD).
At the current market rate of USD 1: EUR 0.6, you expect to receive âŹ750,000 (EUR).
You think the dollar is likely to depreciate against the euro over the next three months. And because the lead-up to completion and exchange of contracts can sometimes take months, you donât want to be exposed to currency risk in the meantime.
So to lock in todayâs rates, you could purchase six future euro contracts (âŹ125,000 per contract) at 0.6 EUR/USD with an expiration date of three months from now. This means youâre obligated to buy âŹ750,000 for $1,250,000 when the contract expires.
At the time of settlement, if the US dollar depreciated to USD 1: EUR 0.5 as you expected, youâd have avoided âŹ12,500 in potential currency losses. Hereâs the maths:
$1.25 million x 0.5 = âŹ625,000 (property value using FX at time of settlement)
âŹ750,000 (the amount hedged in the futures contract) â âŹ625,000 = âŹ12,500
On the other hand, if the US dollar had appreciated hitting USD 1: EUR 0.7, youâd have lost out on âŹ12,500 in potential currency gains.
$1.25 million x 0.7 = âŹ875,000 (property value using FX at time of settlement )
âŹ750,000 (the amount hedged in the futures contract) â âŹ875,000 = ââŹ12,500
What are the risks?
The price of a futures contract depends on factors like interest rates, time until expiration, storage costs, and the price and volatility of the underlying asset. And as always, the type of investor you are dictates the risks you take on.
If youâre purely speculating about the price of an asset, you risk taking a loss if prices move against your expectations. But if youâre using futures to hedge, your loss is limited to missing out on potential gains.
The more leverage used, the higher the risks for investors trading on margin. See, leverage magnifies the effect of even small price changes, so you could end up losing more than your original investment.
Give your expertise in futures a test run đ
Youâve got the basics down, so now itâs time to try futures trading for real.
Well, real to a point. Practice futures trading on the CME Institute Trading Simulator, and give your strategies a test drive and review the outcomes while not putting any real money on the line.
That way, you can note down what did and didnât work, and use CME Groupâs resources to figure out the âwhy.â Therefore, by the time you really start trading, youâll have a wealth of experience. Practice futures trading without any of the risks.
This guide was produced by Finimize in partnership withCME Group.
Check out CMEâs mini-websiteat finimize.com.
Disclaimer: CME Group futures are not suitable for all investors and involve the risk of loss. Full disclaimer. Copyright © 2023 CME Group Inc.